Something for Future Historians To Write About

It’s a crazy idea. After all, it feels like the U.S. is long overdue for a major crisis. But that’s what Janet Yellen thinks. The Fed chair said two weeks ago:

Would I say there will never, ever be another financial crisis? […] Probably that would be going too far. But I do think we’re much safer, and I hope that it will not be in our lifetimes, and I don’t believe it will be.

I couldn’t believe my eyes when I read this. So, I called up Doug Casey to get his take. Maybe he could make sense of this.

Justin: Doug, I know you disagree with Yellen. But I’m wondering why she would even say this? Has she lost her mind?

Doug: Listening to the silly woman say that made me think we’re truly living in Bizarro World. It’s identical in tone to what stock junkies said in 1999 just before the tech bubble burst. She’s going to go down in history as the modern equivalent of Irving Fisher, who said “we’ve reached a permanent plateau of prosperity,” in 1929, just before the Great Depression started.

I don’t care that some university gave her a Ph.D., and some politicians made her Fed Chair, possibly the second most powerful person in the world. She’s ignorant of economics, ignorant of history, and clearly has no judgment about what she says for the record.

Why would she say such a thing? I guess because since she really believes throwing trillions of dollars at the banking system will create prosperity. It started with the $750 billion bailout at the beginning of the last crisis. They’ve since thrown another $4 trillion at the financial system.

All of that money has flowed into the banking system. So, the banking system has a lot of liquidity at the moment, and she thinks that means the economy is going to be fine.

Justin: Hasn’t all that liquidity made the banking system safer?

Doug: No. The whole banking system is screwed-up and unstable. It’s a gigantic accident waiting to happen.

People forgot that we now have a fractional reserve banking system. It’s very different from a classical banking system. I suspect not one person in 1,000 understands the difference…

Modern banking emerged from the goldsmithing trade of the Middle Ages. Being a goldsmith required a working inventory of precious metal, and managing that inventory profitably required expertise in buying and selling metal and storing it securely. Those capacities segued easily into the business of lending and borrowing gold, which is to say the business of lending and borrowing money.

Most people today are only dimly aware that until the early 1930s, gold coins were used in everyday commerce by the general public. In addition, gold backed most national currencies at a fixed rate of convertibility. Banks were just another business—nothing special. They were distinguished from other enterprises only by the fact they stored, lent, and borrowed gold coins, not as a sideline but as a primary business. Bankers had become goldsmiths without the hammers.

Bank deposits, until quite recently, fell strictly into two classes, depending on the preference of the depositor and the terms offered by banks: time deposits, and demand deposits. Although the distinction between them has been lost in recent years, respecting the difference is a critical element of sound banking practice.

Justin: Can you explain the difference between a time deposit and demand deposit?

Doug: Sure.With a time deposit—a savings account, in essence—a customer contracts to leave his money with the banker for a specified period. In return, he receives a specified fee (interest) for his risk, for his inconvenience, and as consideration for allowing the banker the use of the depositor’s money. The banker, secure in knowing he has a specific amount of gold for a specific amount of time, is able to lend it; he’ll do so at an interest rate high enough to cover expenses (including the interest promised to the depositor), fund a loan-loss reserve, and if all goes according to plan, make a profit.

A time deposit entails a commitment by both parties. The depositor is locked in until the due date. How could a sound banker promise to give a time depositor his money back on demand and without penalty when he’s planning to lend it out?

In the business of accepting time deposits, a banker is a dealer in credit, acting as an intermediary between lenders and borrowers. To avoid loss, bankers customarily preferred to lend on productive assets, whose earnings offered assurance that the borrower could cover the interest as it came due. And they were willing to lend only a fraction of the value of a pledged asset, to ensure a margin of safety for the principal. And only for a limited time—such as against the harvest of a crop or the sale of an inventory. And finally, only to people of known good character—the first line of defense against fraud. Long-term loans were the province of bond syndicators.

That’s time deposits.

Justin: And what about demand deposits?

Doug: Demand deposits were a completely different matter.

Demand deposits were so called because, unlike time deposits, they were payable to the customer on demand. These are the basis of checking accounts. The banker doesn’t pay interest on the money, because he supposedly never has the use of it; to the contrary, he necessarily charged the depositor a fee for:

Assuming the responsibility of keeping the money safe, available for immediate withdrawal, and…

Administering the transfer of the money if the depositor so chooses, by either writing a check or passing along a warehouse receipt that represents the gold on deposit.

An honest banker should no more lend out demand deposit money than Allied Van and Storage should lend out the furniture you’ve paid it to store. The warehouse receipts for gold were called banknotes. When a government issued them, they were called currency. Gold bullion, gold coinage, banknotes, and currency together constituted the society’s supply of transaction media. But its amount was strictly limited by the amount of gold actually available to people.

Sound principles of banking are identical to sound principles of warehousing any kind of merchandise—whether it’s autos, potatoes, or books. Or money. There’s nothing mysterious about sound banking. But banking all over the world has been fundamentally unsound since government-sponsored central banks came to dominate the financial system.

Central banks are a linchpin of today’s world financial system. By purchasing government debt, banks can allow the state—for a while—to finance its activities without taxation. On the surface, this appears to be a “free lunch.” But it’s actually quite pernicious and is the engine of currency debasement.

Central banks may seem like a permanent part of the cosmic landscape, but in fact they are a recent invention. The U.S. Federal Reserve, for instance, didn’t exist before 1913.

Justin: What changed after 1913?

Doug: In the past, when a bank created too much currency out of nothing, people eventually would notice, and a “bank run” would materialize. But when a central bank authorizes all banks to do the same thing, that’s less likely—unless it becomes known that an individual bank has made some really foolish loans.

Central banks were originally justified—especially the creation of the Federal Reserve in the US—as a device for economic stability. The occasional chastisement of imprudent bankers and their foolish customers was an excuse to get government into the banking business. As has happened in so many cases, an occasional and local problem was “solved” by making it systemic and housing it in a national institution. It’s loosely analogous to the way the government handles the problem of forest fires: extinguishing them quickly provides an immediate and visible benefit. But the delayed and forgotten consequence of doing so is that it allows decades of deadwood to accumulate. Now when a fire starts, it can be a once-in-a-century conflagration.

Justin: This isn’t just a problem in the US, either.

Doug: Right.Banking all over the world now operates on a “fractional reserve” system. In our earlier example, our sound banker kept a 100% reserve against demand deposits: he held one ounce of gold in his vault for every one-ounce banknote he issued. And he could only lend the proceeds of time deposits, not demand deposits. A “fractional reserve” system can’t work in a free market; it has to be legislated. And it can’t work where banknotes are redeemable in a commodity, such as gold; the banknotes have to be “legal tender” or strictly paper money that can be created by fiat.

The fractional reserve system is why banking is more profitable than normal businesses. In any industry, rich average returns attract competition, which reduces returns. A banker can lend out a dollar, which a businessman might use to buy a widget. When that seller of the widget re-deposits the dollar, a banker can lend it out at interest again. The good news for the banker is that his earnings are compounded several times over. The bad news is that, because of the pyramided leverage, a default can cascade. In each country, the central bank periodically changes the percentage reserve (theoretically, from 100% down to 0% of deposits) that banks must keep with it, according to how the bureaucrats in charge perceive the state of the economy.

Justin: How can a default cascade under the fractional reserve banking system?

Doug: A bank with, say, $1,000 of capital might take in $20,000 of deposits. With a 10% reserve, it will lend out $19,000—but that money is redeposited in the system. Then 90% of that $18,000 is also lent out, and so forth. Eventually, the commercial bank can create hundreds of thousands of loans. If only a small portion of them default, it will wipe out the original $20,000 of deposits—forget about the bank’s capital.

That’s the essence of the problem. But, in the meantime, before the inevitable happens, the bank is coining money. And all the borrowers are thrilled with having dollars.

Justin: Are there measures in place to prevent bank runs?

Doug: In the US and most other places, protection against runs on banks isn’t provided by sound practices, but by laws. In 1934, to restore confidence in commercial banks, the US government instituted the Federal Deposit Insurance Corporation (FDIC) deposit insurance in the amount of $2,500 per depositor per bank, eventually raising coverage to today’s $250,000. In Europe, €100,000 is the amount guaranteed by the state.

FDIC insurance covers about $9.3 trillion of deposits, but the institution has assets of only $25 billion. That’s less than one cent on the dollar. I’ll be surprised if the FDIC doesn’t go bust and need to be recapitalized by the government. That money—many billions—will likely be created out of thin air by selling Treasury debt to the Fed.

The fractional reserve banking system, with all of its unfortunate attributes, is critical to the world’s financial system as it is currently structured. You can plan your life around the fact the world’s governments and central banks will do everything they can to maintain confidence in the financial system. To do so, they must prevent a deflation at all costs. And to do that, they will continue printing up more dollars, pounds, euros, yen, and what-have-you.

Justin: It sounds like the banking system is more fragile than it was a decade ago…not stronger.

Doug: Correct. So, Yellen isn’t just delusional. As I said before, she has no grasp whatsoever of basic economics.

Her comments remind me of what Ben Bernanke said in May 2007.

We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.

A few months later, the entire financial system started to unravel. You would have actually lost a fortune if you listened to Bernanke back then.

Justin: I take it investors shouldn’t listen to Yellen, either?

Doug: No. These people are all academics. They don’t have any experience in the real world. They’ve never been in business. They were taught to believe in Keynesian notions. These people have no idea what they’re talking about.

The Fed itself serves no useful purpose. It should be abolished.

But people look up to authority figures, and “experts.” The average guy has other things on his mind.

Justin: So if Yellen’s wrong, what should investors prepare for? How will the coming crisis be different from what we saw in 2007–2008?

Doug: Well, as you know, the Fed has dropped interest rates to near zero. I used to think it was metaphysically impossible for rates to drop below zero. But the European and Japanese central banks have done it.

The other thing they did was create megatons of money out of thin air. This hasn’t just happened in the U.S., either. Central banks around the world have printed up trillions of currency units.

How many more can they print at this point? I guess we’ll find out. Plus, it’s not like these dollars have gone to the retail economy the way they did during the “great inflation” of the ’70s. This time they went straight into the financial system. They’ve created bubbles everywhere.

That’s why the next crisis is going to be far more serious than what we saw a decade ago.

Justin: Is there anything the Fed can do to stop this? What would you do if you were running the Fed?

Doug: I’ve been saying for years that I would abolish the Fed, end the fractional reserve system, and default on the national debt. But would I actually do any of those things? No. I wouldn’t. I pity the poor fool who allows the rotten structure to collapse on his watch. Perish the thought of bringing it down in a controlled demolition.

They would literally crucify the person who did this…even if it was good for the economy in the long run. Which it would be.

So, these people are going to keep doing what they’ve been doing. They’re hoping that, if they kick the can down the road, something magic will happen. Maybe friendly aliens will land on the roof of the White House and cure everything.

Justin: So, they can’t stop what’s coming?

Doug: The whole financial system is on the ragged edge of a collapse at this point.

All these paper currencies all around the world could lose their value together. They’re all based on the dollar quite frankly. None of them are tied to any commodity.

They have no value in and of themselves, aside from being mediums of exchange. They’re all just floating abstractions, based on nothing.

When we exit the eye of this financial hurricane, and go into the storm’s trailing edge, it’s going to be something for the history books written in the future.